Friday, January 7, 2011

The Great Inflation Debate?

Worried about inflation? Neither Federal Reserve Chairman Ben Bernanke nor all those traders currently dumping gold seem to be, but that may be the best time to make sure you're covered if prices go haywire.

Some people think the combination of an expansive Fed policy and an expansive fiscal policy make that inevitable. Oh, and as I'm writing this, the United Nations is announcing that world food prices are at an all-time high.

The last time consumer prices went crazy, it happened pretty fast: They rose roughly 3 percent in 1971, 6 percent in 1972, and 12 percent in 1973, according to the Labor Department's Consumer Price Index data. Back then, it took almost a decade and a deep recession to get that genie back in the bottle.

Loeper, a former adviser to the Virginia Retirement System, recently studied the behavior of anti-inflation assets during inflationary periods. He concluded that the payoffs for hedging inflation might not be worth the extra trading and holding costs.

"Adding gold and real estate to a 60/40 (60 percent stocks, 40 percent bonds) portfolio looks pretty similar to a 50/50 balanced portfolio," he wrote. "Those extra positions... are certain to add cost... and do not appear to be worth much unless we do have that perfect storm" of an unusual and severe double-spike in inflation.

Loeper looked at the most recent three major periods of inflation and observed that there was not one asset class that produced positive real returns in all three periods. Because gold, in particular, has been bid up as a safety plan during recent low-inflation years, he's concerned that it may not perform its typical anti-inflation role when prices rise.

The yes-it's-coming/no-it-isn't debate about inflation can be seen in market prices and consumer expectations, too. Both bond market swaps and inflation-protected securities seem priced with an expectation that prices will rise a modest 1.5 percent or so, says Olsen.

But consumers responding to the Conference Board's last survey had a different view: They expect prices to rise about 5.3 percent in the next 12 months.

So, what's an investor to do? Here are some tips for preparing for a run-up in prices, which may or may not materialize.

* Let some investments do double duty. Loeper and Olsen agree on this: Some investments already in your portfolio might protect against inflation without being strictly anti-inflation plays. For example, if you own a large-cap stock fund, you probably already own shares of Exxon Mobil Corp. or Weyerhaeuser, two traditional inflation-fighters.

Similarly, Olsen's clients own foreign stocks; they'll be some protection if runaway prices hurt the U.S. dollar more than other currencies.

* Go long on items you'll use. Not all investments happen in your brokerage account. If you're a year or two away from buying a new car, lawnmower or retirement house, think about buying now while prices and interest rates are comparatively low. You can stockpile canned goods and paper towels, too, but not to the extent that you end up on A&E TV's reality show, "Hoarders."

* Keep carrying-costs low. There are now many inexpensive exchange-traded funds which focus on commodities and other anti-inflation strategies. Many are available for an annual expense charge well below 0.8 percent.

* Stay safe. You may lose purchasing power, but you won't lose money by buying individual Treasury inflation-protected bonds and holding them to maturity. Yields are low, but guaranteed to rise as the CPI does. The big risk there? If interest rates rise faster than prices, you could find yourself losing ground to better-yielding short-term securities.

Is inflation the real threat going forward? The answer is nobody really knows for sure. Inflation is already present in China and emerging markets, but it has not picked up significantly in the US and Europe. We are likely to see higher energy prices, but even this is not enough to kick start a severe inflationary episode. Only wage inflation can do this, and to compare what is going on now with the 1970s is simply wrong. Despite December job gains, unemployment remains stubbornly high, unions are not as strong as they used to be, and the structure of the global economy has changed significantly in the last three decades.

Demographics, global competition, the internet, deleveraging, are all factors weighing down inflation. It is possible that we start importing inflation, but even this is debatable. Bottom line: the great inflation debate will continue for quite some time, and while you should hedge against all scenarios, be careful not to jump on any inflation bandwagon. Deflation hasn't died; it might just be hibernating.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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